Thursday, March 6, 2008

Non-Borrowed Reserves

In the comments over at Angry Bear, Edward Charles Ponzi Jr. pointed to a major recent development in the Fed's reports on non-borrowed reserves at banks. I put together a figure that illustrates this "change":This is non-borrowed reserves held by banks per week since 1975. You can see it that it varies little over the long term. It looks like reserves increased in 1985 (maybe related to Plaza Accords or unwinding of the dollar?) and started to drop in about 1995. There is a VERY sharp peak right after 9/11 2001, which makes sense given the uncertainties following the attacks on the WTC, a major financial hub. Then it basically holds steady, except it appears to be much more variable from week to week.

But in Jan 08, a funny thing happens. Non-borrowed reserves go from about $40 billion to -$20 billion in about three weeks time. WTF? Seems bad, right?

Well, it sounds like it might be that banks are making heavy use of the Term Auction Facility (TAF). This is a device created by the fed to ease the liquidity crunch and encourage lending between banks and others. They already have a method of doing that called the discount window. But there are some major differences between the discount window and TAF. Caroline Baum at Bloomberg explained this difference:

Q: What is the difference between the discount window and the TAF?

A: About 50 basis points, at least at the Feb. 25 TAF auction. The minimum bid at the auction is determined by the expected fed funds rate over the term of the loan, which is 28 days.

The Fed awarded $30 billion at 3.08 percent last week. The discount rate is 3.5 percent. (That rate doesn't include the implied cost of any stigma that accrues to the borrower for going to the window.)

Also:

The Fed had already taken steps in August to encourage banks to borrow directly from its discount window, compressing the spread of the discount rate over the federal funds rate to 50 basis points from 100 and expanding both the type of collateral it would accept and the terms of the loans to 30 days.

No matter how nicely the Fed asked, banks were unwilling to incur the stigma associated with discount window borrowing, especially at a time when financial institutions were reporting large losses and any intimation of trouble could cause depositors to take flight.

Fed Chairman Ben Bernanke decided to respond to the liquidity crisis with, appropriately, added liquidity. (See ``Federal Reserve'' and ``lender of last resort.'') That didn't stop the yammering about the assumption of credit risk by the central bank.

A number of people on Wall Street have noticed a recent plunge in non-borrowed reserves in the banking system and wondered it is a sign of distress in the banking system or of unusually stringent monetary policy. They dropped from $42 billion last November to negative $2 billion at the end of January.

It’s probably a false alarm, though. The drop is purely technical, a function of how the Fed has chosen to classify the money lent through its new Term Auction Facility.

Some background. All banks are required to hold some reserves in the form of either cash on deposit at the Fed or currency in their vaults. The Fed manages interest rates by increasing or decreasing these reserves. The Fed ordinarily does this through open market operations: It buys, usually temporarily, Treasury bonds and bills from dealers, and the funds get deposited in the dealers’ bank accounts at the Fed. That causes reserves to go up. Banks usually lend out anything in excess of their requirements, putting downward pressure on the federal-funds rate. Banks also obtain reserves by borrowing at the discount window, which often occurs if they fall short of their regulatory requirement.

According to economic theory, the Fed can target either the price (interest rate) or the quantity of reserves, but not both. Back when the Fed hated to admit it controlled interest rates, it targeted reserves. Since the amount banks borrowed from the discount window was somewhat beyond their control, they focused on reserves minus discount window borrowings, or “non-borrowed reserves.” In 1990, the Fed began to explicitly target the federal funds rate in one of its most important and least appreciated moves towards greater transparency. Since discount window loans were usually pretty small, total reserves and non-borrowed reserves were pretty close.

Last December, the Fed concluded that open market operations weren’t providing relief to some quarters of the interbank funding market and introduced the TAF. Like open market operations, the TAF enabled the Fed to lend a predetermined amount of funds to the banking system, with the interest rate at which they were lent determined through an auction process. But like the discount window, the money was lent directly to banks rather than primary dealers, and against a wide range of collateral rather than just Treasurys and agency securities. The TAF didn’t add to the money supply because for each dollar lent through the TAF the Fed was careful to liquidate a dollar of its holdings of Treasury bills and bonds to keep its overall balance sheet unchanged. But because the TAF is essentially discount window credit, the Fed decided to classify it as borrowed reserves.

OK, so it's all just a misunderstanding, right? Well, take a look at most of the comments at the WSJ blog post. They're not buying it. Some examples:

Carl:So borrowing from the TAF is counted very much like borrowing from the discount window? What you are telling us then is that banks found it advantageous to borrow $50 Billion from the functional equivalent of the discount window (formerly used only by banks in trouble as there was a perceived stigma) and that this is business as usual?The clear purpose of the TAF is to allow banks in difficulty to borrow from the Fed ANONYMOUSLY so as to avoid the stigma previously attached to the discount window (which was not anonymous). TAF borrowing allows banks to post as collateral assets that are not marketable and therefore to obtain cash that is needed for either reserves or lending without trying to sell assets into a nonfunctional market.While the TAF is a clever and useful addition to the Fed’s toolkit, its heavy use last month indicates that a crisis did exist and was at least partially resolved. I suspect that the TAF will need to be used again soon as certain structural problems will cause further capital losses to the banks. False alarm, indeed.

Where is George Orwell when we need him for this blog “Non-Borrowed Reserves: False Alarm”.

How about this Orwellian beauty: “The drop is purely technical, a function of how the Fed has chosen to classify the money lent through its new Term Auction Facility.” Isn’t that a sweet way to deal with a drop from $42 billion to negative $2 billion.Purely technical, my good man. Why it’s just a matter of how you classify things…how you view things. If you stand on your head and look at the world, up is down, and down is up.

The key quote: “But like the discount window, the money was lent directly to banks rather than primary dealers, and against a wide range of collateral rather than just Treasurys and agency securities.”

Yes, my good man, a wide range of collateral rather than just stodgy old low-yielding Treasurys and agency securities. The Fed can make great returns by taking these high-yielding, mortgage-backed CDOs as collateral.

So, the Fed is lowering lending standards…precisely the behavior that created the subprime fiasco. The Fed is supposed to set the standard for good behavior, for a sound and sober central bank. But don’t be alarmed. It’s just a technicality…just a matter of how you classify things.

My concern is that the powers that be are all treating the Fed's Term Auction Facility, which was created to deal with money market stress, as no big deal. The operation of the TAF is what leads to the negative net non-borrowed reserves.

I am bothered that an emergency facility, which was initially presented as "let's try it a couple of times and see how it goes," has not only become pretty permanent, but has been enlarged with little fanfare (it went from $40 billion in outstandings to $60 billion). And per some recent sightings, such as a WSJ story just posted, the money markets are looking rocky again.

There's more on this issue, especially from the doom-and-gloom contingent. If I get enough done today, I'll look over what they have to say and post more later. I'll also keep an eye on this issue from here on out.